Written by

Pralhad Burli

Published

January 16, 2013

The Indian economy appears to be stuck in low-level equilibrium. The country’s GDP grew 5.3 percent in the second quarter of the 2012–2013 fiscal year—one of its lowest quarterly growth rates in the last decade. Investments have been lackluster, but the government hopes that its recent push for reforms will help trigger investments and jumpstart the economy. Meanwhile, the central bank remains jittery about elevated inflation and may be wary of prematurely slashing its policy rate. Although the economy is expecting the government to provide the necessary boost, the government is unable to increase its spending due to a widening budget deficit. Nonetheless, the economy is expected to perform better over the next two quarters, which is a positive sign amid a host of macroeconomic challenges.

Jumping political hurdles

The motion against the decision to allow foreign direct investment (FDI) in the country’s multi-brand retail sector took center stage at the onset of parliament’s winter session. The government announced that it would open six sectors to foreign investment, and politically, multi-brand retail was the trickiest. Following several rounds of debates, the United Progressive Alliance, the ruling coalition, emerged victorious in both houses of parliament. This is a big boost for the government because it managed to garner the support of smaller regional parties who voted in their favor. The government will likely face less political pressure in the future, but farmer and trader unions could up the ante in the coming months. However, the central government’s worries are limited because the responsibility of implementation lies largely with individual state governments.

The policy allows foreign players to invest up to 51 percent in multi-brand retail, subject to certain restrictions. Retail stores can be opened only in cities with a population of more than 1 million. In addition, the minimum investment must be $100 million, and at least 50 percent of the investment must be in back-end infrastructure within three years. International retail chains deferred their India plans amid political uncertainty and widespread protests. However, the outcome of the parliamentary vote may hasten their entry into states that have already announced their support for FDI in the retail sector. Moreover, foreign investors looking to invest in aviation, insurance, pensions, and the utilities sectors could become more optimistic about prospects for those sectors.

Has growth bottomed out?

According to the seasonally adjusted HSBC Services Purchasing Managers Index, India’s services sector growth declined to 52.1 in November—its slowest pace in 13 months—from 53.8 in the previous month. Yet, the index has remained above the 50 mark since November 2011, which suggests an expansion. Moreover, service providers are optimistic about the short-term business outlook. Meanwhile, in November, the HSBC Manufacturing Purchasing Managers Index expanded at its fastest rate in five months. The index rose to 53.7 in November from 52.9 in October because of an uptick in new orders. The index provides evidence of an uptick in manufacturing activity, and the recent performance of the infrastructure sector provides hope for higher growth in the coming months. In addition, the sub-index for new export orders rose to a six-month high of 55.9 in November, suggesting a recovery in exports and broad-based factory output.

Overall, the Indian economy is showing early signs of a recovery, suggesting that the deceleration may have bottomed out. Auto sales and production of consumer goods have stabilized over the past two months. The Index of Industrial Production grew 8.2 percent in October, its fastest pace in more than a year. Economic activity, supported by an improvement in the industry and services segments, is expected to improve. Furthermore, a decline in crude oil prices could further boost GDP growth. Moreover, the global recovery may pick up in near future provided none of the economies face major set-backs in their recovery. Positive economic data from China, improved manufacturing activity in the United Kingdom, a modest GDP acceleration in the United States, and structural reforms in Greece all suggest an improving outlook for the global economy, which augurs well for India’s growth.

Looking at the central bank for help

The Reserve Bank of India (RBI) cut its policy rate by 50 basis points in April, but it has not tinkered with the policy rate since. Instead, the RBI has reduced the cash reserve ratio (CRR) by a cumulative 75 basis points in 2012. A CRR cut adds liquidity and enhances credit availability, which could impact both deposit and lending rates. But, financial markets and industries have not been satisfied with the RBI’s monetary stance, consistently demanding a policy rate cut.

The Indian economy is trapped between a burgeoning fiscal deficit, low investments, elevated inflation, and high interest rates.

The Wholesale Price Index-based inflation stood at 7.45 percent in October, slightly lower than 7.81 in the previous month. During the current fiscal year, headline inflation has hovered between 7 and 8 percent. Meanwhile, retail inflation surged 9.9 percent in November following readings of 9.75 percent in October and 9.73 percent in September. The hawks would argue that, at its current level, inflation remains uncomfortably high. Furthermore, the government has not made significant headway in terms of fiscal consolidation. The government’s budgeted growth estimate of 7.6 percent is a far cry from the current growth rate of 5.3–5.5 percent. As a result, projected tax revenues will be very difficult to achieve. Moreover, the telecom spectrum auction left a gaping hole in the government’s collection target. Spectrum sale proceeds came in at approximately $1.7 billion against the government’s estimate of $5.5 billion. Finally, little progress has been made on disinvestment in public-sector undertakings. As a result, movement toward fiscal consolidation is unlikely to be a trigger for cutting policy rates.

On the other hand, the doves would make a case for a rate cut given India’s high interest rate environment and decelerating growth. However, the RBI governor has resisted a policy rate cut since the inflation rate is still beyond the central bank’s comfort zone. Clearly, the RBI’s focus remains on inflation containment and it believes that its current policy stance will likely anchor inflation expectations. The RBI is caught between a rock and a hard place, and its policy stance will once again come under the spotlight in its next policy meeting. It is likely that the RBI may once again choose to lower the CRR and hold back on a policy rate cut until inflation recedes to manageable levels.

A rush toward external borrowing

Following the central bank’s decision to raise the limit for external commercial borrowing, Indian companies are increasingly turning to overseas markets to raise funds—a trend likely to continue over the next few months. According to the new regulation, a company can borrow offshore funds to the tune of 75 percent of the average foreign exchange earnings in the immediate past or 50 percent of the highest foreign exchange earnings realized in the past three years, whichever is higher. The previous limit was 50 percent. This measure will likely serve twin benefits. It could bring some stability to the rupee’s movement against the US dollar. Furthermore, Indian companies can save on interest costs by borrowing at cheaper rates in overseas markets. Therefore, companies with significant overseas presence could benefit through overseas borrowing for new investments or for paying-off costly domestic debt. On the other hand, loose monetary policies in western markets have resulted in a low interest environment, and banks’ are sitting on massive cash reserves. As a result, foreign banks are happy to lend to Indian companies as they have relatively favorable growth prospects.

The Indian economy is trapped between a burgeoning fiscal deficit, low investments, elevated inflation, and high interest rates. It is difficult to ascertain how the country will break out of this vicious cycle. While the global economy is recovering, downside risks loom large. India’s GDP has grown at an average rate of 5.4 percent during the first half of the current fiscal year, and the economy may end the year at a slightly higher growth level. A push for reforms is certainly encouraging, but successful implementation of these reforms is vital, and it may take a while before growth returns to its pre-crisis level.